Mortgage Banking Comptroller’s Handbook docx

Mortgage-backed securities, in particular, have attracted moreinvestors into the market by providing a better blend of risk profiles than individual loans.Fundamentals of Mortgage Bankin

Mortgage Banking

Comptroller’s Handbook

Narrative - March 1996, Procedures - March 1998

I-MB

Comptroller of the Currency

Administrator of National Banks

I

Mortgage Banking Table of Contents

Mortgage Banking Introduction

Background

Depository institutions have traditionally originated residential mortgage loans to hold in their loan portfolios, and mortgagebanking is a natural extension of this traditional origination process Although it can include loan origination, mortgagebanking goes beyond this basic activity A bank that only originates and holds mortgage loans in its loan portfolio has not

engaged in mortgage banking as defined here Those activities are discussed elsewhere in the Comptroller’s

Handbook

Mortgage banking generally involves loan originations, purchases, and sales through the secondary mortgage market

A mortgage bank can retain or sell loans it originates and retain or sell the servicing on those loans Through mortgagebanking, national banks can and do participate in any or a combination of these activities Banks can also participate inmortgage banking activities by purchasing rather than originating loans

The mortgage banking industry is highly competitive and involves many firms and intense competition Firms engaged

in mortgage banking vary in size from very small, local firms to exceptionally large, nationwide operations Commercialbanks and their subsidiaries and affiliates make up a large and growing proportion of the mortgage banking industry.Mortgage banking activities generate fee income and provide cross-selling opportunities that enhance a bank’s retailbanking franchise The general shift from traditional lending to mortgage banking activities has taken place in the context

of a more recent general shift by commercial banks from interest income activities to non-interest, fee generatingactivities

Primary and Secondary Mortgage Markets

The key economic function of a mortgage lender is to provide funds for the purchase or refinancing of residential

properties This function takes place in the primary mortgage market where mortgage lenders originate mortgages by lending funds directly to homeowners This market contrasts with the secondary mortgage market In the secondary

mortgage market, lenders and investors buy and sell loans that were originated directly by lenders in the primarymortgage market Lenders and investors also sell and purchase securities in the secondary market that are

collateralized by groups of pooled mortgage loans

Banks that use the secondary market to sell loans they originate do so to gain flexibility in managing their long-terminterest rate exposures They also use it to increase their liquidity and expand their opportunities to earn fee-generatedincome

The secondary mortgage market came about largely because of various public policy measures and programs aimed

at promoting more widespread home ownership Those efforts go as far back as the 1930s Several government-runand government-sponsored programs have played an important part in fostering home ownership, and are still important

in the market today The Federal Housing Administration (FHA), for example, encourages private mortgage lending byproviding insurance against default The Federal National Mortgage Association (FNMA or Fannie Mae) supportsconventional, FHA and Veteran’s Administration (VA) mortgages by operating programs to purchase loans and turnthem into securities to sell to investors (For a more complete description of government-run and government-

sponsored programs, see Appendix.)

Most of the loans mortgage banks sell are originated under government-sponsored programs These loans can besold directly or converted into securities collateralized by mortgages Mortgage banks also sell mortgages and

mortgage-backed securities to private investors Mortgage-backed securities, in particular, have attracted moreinvestors into the market by providing a better blend of risk profiles than individual loans.

Fundamentals of Mortgage Banking

When a bank originates a mortgage loan, it is creating two commodities, a loan and the right to service the loan Thesecondary market values and trades each of these commodities daily Mortgage bankers create economic value byproducing these assets at a cost that is less than their market value

Given the cyclical nature of mortgage banking and the trend to greater industry consolidation, banks must maximizeefficiencies and economies of scale to compete effectively Mortgage banking operations can realize efficiencies byusing systems and technology that enhance loan processing or servicing activities The largest mortgage servicingoperations invest heavily in technology to manage and process large volumes of individual mortgages with differingpayments, taxes, insurance, disbursements, etc They also operate complex telephone systems to handle customerservice, collections, and foreclosures This highly developed infrastructure enables mortgage banks to effectively handlelarge and rapidly growing portfolios

Mortgage banking operations also need effective information systems to identify the value created and cost incurred toproduce different mortgage products This is especially critical for banks that retain servicing rights To optimizeearnings on servicing assets, mortgage banks must have cost-efficient servicing operations and effective, integratedinformation systems

Risks Associated with Mortgage Banking

For purposes of the OCC’s discussion of risk, examiners assess banking risk relative to its impact on capital andearnings From a supervisory perspective, risk is the potential that events, expected or unanticipated, may have anadverse impact on the bank’s capital or earnings The OCC has defined nine categories of risk for bank supervision

purposes These risks are: Credit, Interest Rate, Liquidity, Price, Foreign Exchange, Transaction, Compliance,

Strategic, and Reputation These categories are not mutually exclusive; any product or service may expose the bank

to multiple risks For analysis and discussion purposes, however, the OCC identifies and assesses the risks

separately

The applicable risks associated with mortgage banking are: credit risk, interest rate risk, price risk, transaction

risk, liquidity risk, compliance risk, strategic risk, and reputation risk These are discussed more fully in the

following paragraphs

Credit Risk

Credit risk is the risk to earnings or capital arising from an obligor’s failure to meet the terms of any contract with the bank

or to otherwise fail to perform as agreed Credit risk is found in all activities where success depends on counterparty,issuers, or borrower performance It arises any time bank funds are extended, committed, invested, or otherwiseexposed through actual or implied contractual agreements, whether reflected on or off the balance sheet

In mortgage banking, credit risk arises in a number of ways For example, if the quality of loans produced or serviceddeteriorates, the bank will not be able to sell the loans at prevailing market prices Purchasers of these assets willdiscount their bid prices or avoid acquisition if credit problems exist Poor credit quality can also result in the loss offavorable terms or the possible cancellation of contracts with secondary market agencies

For banks that service loans for others, credit risk directly affects the market value and profitability of a bank’s mortgageservicing portfolio Most servicing agreements require servicers to remit principal and interest payments to investors

and keep property taxes and hazard insurance premiums current even when they have not received payments frompast due borrowers These agreements also require the bank to undertake costly collection efforts on behalf of

investors

A bank is also exposed to credit risk when it services loans for investors on a contractual recourse basis and retainsrisk of loss arising from borrower default When a customer defaults on a loan under a recourse arrangement, the bank

is responsible for all credit loss because it must repurchase the loan serviced

A related form of credit risk involves concentration risk Concentration risk can occur if a servicing portfolio is composed

of loans in a geographic area that is experiencing an economic downturn or if a portfolio is composed of nonstandardproduct types

A mortgage bank can be exposed to counterparty credit risk if a counterparty fails to meet its obligation, for examplebecause of financial difficulties Counterparties associated with mortgage banking activities include broker/dealers,correspondent lenders, private mortgage insurers, vendors, subservicers, and loan closing agents If a counterpartybecomes financially unstable or experiences operational difficulties, the bank may be unable to collect receivables owed

to it or may be forced to seek services elsewhere Because of its exposure to the financial performance of

counterparties, a bank should monitor counterparties’ actions on a regular basis and should perform appropriateanalysis of their financial stability

Interest Rate Risk

Interest rate risk is the risk to earnings or capital arising from movements in interest rates The economic perspectivefocuses on the value of the bank in today’s interest rate environment and the sensitivity of that value to changes in interestrates Interest rate risk arises from differences between the timing of rate changes and the timing of cash flows (repricingrisk); from changing rate relationships among different yield curves affecting bank activities (basis risk); from changingrate relationships across the spectrum of maturities (yield curve risk); and from interest-related options embedded inbank products (options risk) The evaluation of interest rate risk must consider the impact of complex, illiquid hedgingstrategies or products, and also the potential impact on fee income which is sensitive to changes in interest rates Inthose situations where trading is separately managed this refers to structural positions and not trading positions

Changes in interest rates pose significant risks to mortgage banking activities in several ways Accordingly, effectiverisk management practices and oversight by the Asset/Liability Committee, or a similar committee, are essentialelements of a well-managed mortgage banking operation These practices are described below in the Managementand Overall Supervision section of the Introduction

Higher interest rates can reduce homebuyers’ willingness or ability to finance a real estate loan and, thereby, canadversely affect a bank that needs a minimum level of loan originations to remain profitable Rising interest rates,however, can increase the cash flows expected from the servicing rights portfolio and, thus, increase both projectedincome and the value of the servicing rights Falling interest rates normally result in faster loan prepayments, which canreduce cash flows expected from the rights and the value of the bank’s servicing portfolio

Price Risk

Price risk is the risk to earnings or capital arising from changes in the value of portfolios of financial instruments Thisrisk arises from market-making, dealing, and position-taking activities in interest rate, foreign exchange, equity, andcommodities markets

Price risk focuses on the changes in market factors (e.g., interest rates, market liquidity, and volatilities) that affect the

value of traded instruments Rising interest rates reduce the value of warehouse loans and pipeline commitments, and

can cause market losses if not adequately hedged

Falling interest rates may cause borrowers to seek more favorable terms and withdraw loan applications before theloans close If customers withdraw their applications, a bank may be unable to originate enough loans to meet itsforward sales commitments Because of this kind of “fallout,” a bank may have to purchase additional loans in thesecondary market at prices higher than anticipated Alternatively, a bank may choose to liquidate its commitment to selland deliver mortgages by paying a fee to the counterparty, commonly called a pair-off arrangement (For definition of

these terms, see pair-off arrangement and pair-off fee in the Glossary.)

Transaction Risk

Transaction risk is the risk to earnings or capital arising from problems with service or product delivery This risk is afunction of internal controls, information systems, employee integrity, and operating processes Transaction risk exists inall products and services

To be successful, a mortgage banking operation must be able to originate, sell, and service large volumes of loansefficiently Transaction risks that are not controlled can cause the company substantial losses

To manage transaction risk, a mortgage banking operation should employ competent management and staff, maintaineffective internal controls, and use comprehensive management information systems To limit transaction risk, a bank’sinformation and recordkeeping systems must be able to accurately and efficiently process large volumes of data Because of the large number of documents involved and the high volume of transactions, detailed subsidiary ledgersmust support all general ledger accounts Similarly, accounts should be reconciled at least monthly and be supported

by effective supervisory controls

Excessive levels of missing collateral documents are another source of transaction risk If the bank has a large number

of undocumented loans in its servicing portfolio, purchasers will not be willing to pay as high a price for the portfolio Tolimit this risk, management should establish and maintain control systems that properly identify and manage this

exposure

Mortgage servicers are exposed to considerable transaction risk when they perform escrow administration anddocument custodian activities As the escrow account administrator, the servicer must protect borrowers’ funds andmake timely payments on their behalf to taxing authorities, hazard insurance providers, and other parties The serviceralso must ensure that escrow accounts are maintained within legal limits As document custodian, the institution mustobtain, track, and safekeep loan documentation for investors

Liquidity Risk

Liquidity risk is the risk to earnings or capital arising from a bank’s inability to meet its obligations when they come due,without incurring unacceptable losses Liquidity risk includes the inability to manage unplanned decreases or changes infunding sources Liquidity risk also arises from the bank’s failure to recognize or address changes in market conditionsthat affect the ability to liquidate assets quickly and with minimal loss in value

In mortgage banking, credit and transaction risk weaknesses can cause liquidity problems if the bank fails to underwrite

or service loans in a manner that meets investors’ requirements As a result, the bank may not be able to sell mortgageinventory or servicing rights to generate funds Additionally, investors may require the bank to repurchase loans sold tothe investor which the bank inappropriately underwrote or serviced

Compliance Risk

Compliance risk is the risk to earnings or capital arising from violations of, or non-conformance with, laws, rules,regulations, prescribed practices, or ethical standards Compliance risk also arises in situations where the laws or rulesgoverning certain bank products or activities of the bank’s clients may be ambiguous or untested Compliance riskexposes the institution to fines, civil money penalties, payment of damages, and the voiding of contracts Compliancerisk can lead to a diminished reputation, reduced franchise value, limited business opportunities, lessened expansionpotential, and lack of contract enforceability

A bank that originates and/or services mortgages is responsible for complying with applicable federal and state laws For example, when a bank or its agent fails to comply with laws requiring servicers to pay interest on a borrower’sescrow account balance, the bank may become involved in, and possibly incur losses from, litigation In addition, failure

to comply with disclosure requirements, such as those imposed under the Truth-in-Lending Act, could make the bank atarget of class-action litigation

Mortgage banking managers must be aware of fair lending requirements and implement effective procedures andcontrols to help them identify practices that could result in discriminatory treatment of any class of borrowers Forexample, selectively increasing the price of a mortgage loan above the bank’s established rate to certain customers(“overages”) may have the effect of discriminating against those customers This practice, left undetected and notproperly controlled, may raise the possibility of litigation or regulatory action (For a more complete discussion of fair

lending, see the “Community Bank Consumer Compliance” booklet.)

Strategic Risk

Strategic risk is the risk to earnings or capital arising from adverse business decisions or improper implementation ofthose decisions This risk is a function of the compatibility of an organization’s strategic goals, the business strategiesdeveloped to achieve those goals, the resources deployed against those goals, and the quality of implementation Theresources needed to carry out business strategies are both tangible and intangible They include communicationchannels, operating systems, delivery networks, and managerial capacities and capabilities

In mortgage banking activities, strategic risk can expose the bank to financial losses caused by changes in the quantity

or quality of products, services, operating controls, management supervision, hedging decisions, acquisitions,

competition, and technology If these risks are not adequately understood, measured, and controlled, they may result inhigh earnings volatility and significant capital pressures A bank’s strategic direction is often difficult to reverse on a short-term basis, and changes usually result in significant costs

To limit strategic risk, management should understand the economic dynamics and market conditions of the industry,including the cost structure and profitability of each major segment of mortgage banking operations, to ensure initiativesare based upon sound information Management should consider this information before offering new products andservices, altering its pricing strategies, encouraging growth, or pursuing acquisitions Additionally, management shouldensure a proper balance exists between the mortgage company’s willingness to accept risk and its supporting

resources and controls The structure and managerial talent of the organization must support its strategies and degree ofinnovation

Reputation Risk

Reputation risk is the risk to earnings or capital arising from negative public opinion This affects the institution’s ability toestablish new relationships or services, or continue servicing existing relationships This risk can expose the institution

to litigation, financial loss, or damage to its reputation Reputation risk exposure is present throughout the organizationand is why banks have the responsibility to exercise an abundance of caution in dealing with its customers and

community This risk is present in activities such as asset management and agency transactions

An operational breakdown or general weakness in any part of its mortgage banking activities can harm a bank’sreputation For example, a mortgage bank that services loans for third party investors bears operational and

administrative responsibilities to act prudently on behalf of investors and borrowers Misrepresentations, breaches ofduty, administrative lapses, and conflicts of interest can result in lawsuits, financial loss, and/or damage to the company’sreputation In addition, a bank that originates and sells loans into the secondary market should follow effective

underwriting and documentation standards to protect its reputation in the market to support future loan sales

Statutory and Regulatory Authority

Twelve USC 371 provides the statutory authority for a national bank to engage in mortgage banking activities It permitsnational banks to make, arrange, purchase, or sell loans or extensions of credit secured by liens or interests in realestate Twelve CFR 34 clarifies the types of collateral that qualify as real estate Finally, 12 CFR 7.7379 permits anational bank, either directly or through a subsidiary, to act as agent in the warehousing and servicing of mortgage loans

Capital Requirements

Banks that engage in mortgage banking activities must comply with the OCC’s risk-based capital and leverage ratio

requirements that apply to those activities (For a more complete discussion of OCC capital requirements, see the Capital and Dividends section of the Comptroller’s Handbook.)

In addition to the OCC’s requirements, the Federal Home Loan Mortgage Corporation (FHLMC), FNMA, and

Government National Mortgage Association (GNMA) require banks, nonbanks, and individuals conducting businesswith them to maintain a minimum level of capital Failure to satisfy any agency’s minimum capital requirement mayresult in the bank losing the right to securitize, sell, and service mortgages for that agency Since the capital

requirements are different for each agency, examiners should determine if the bank or its mortgage banking subsidiarymeets the capital requirements of each agency with which it has a relationship

Management and Overall Supervision

The success of a mortgage banking enterprise depends on strong information systems, efficient processing, effectivedelivery systems, knowledgeable staff, and competent management Weaknesses in any of these critical areas coulddiminish the bank’s ability to respond quickly to changing market conditions and potentially jeopardize the organization’sfinancial condition

The activities that comprise mortgage banking are interdependent The efficiency and profitability of a mortgage bankingoperation hinges on how well a bank manages these activities on a departmental and institutional basis

Because mortgage banking encompasses numerous activities that pose significant risks, the bank should haveeffective policies and strong internal controls governing each operational area Effective policies and internal controlsenable the bank to adhere to its established strategic objectives and to institutionalize effective risk management

practices Policies also can help ensure that the bank benefits through efficiencies gained from standard operatingprocedures Further, policies provide mortgage banking personnel with a consistent message about appropriateunderwriting standards needed to ensure that loans made are eligible for sale into the secondary market

The requirement for effective policies and internal controls does not alter a bank’s designation as noncomplex TheOCC, however, requires banks to have written mortgage banking policies unless the risk in their activity is so small that

it is considered de minimis.

An effective risk management program is a key component of management’s supervision The board of directors andsenior management should define the mortgage banking operation’s business strategies, permissible activities, lines ofauthority, operational responsibilities, and acceptable risk levels

In developing a strategic plan, management should assess current and prospective market conditions and industrycompetition It is essential that a sufficient long-term resource commitment exists to endure the cyclical downturnsendemic in this industry If the company intends to be a niche player, management should clearly delineate its targetedmarket segment and develop appropriate business strategies

A mortgage banking operation’s business plan should include specific financial objectives The plan should be

consistent with the bank’s overall strategic plan and describe strategies management intends to pursue when acquiring,selling, and servicing mortgage banking assets The plan should also provide for adequate financial, human,

technological, and physical resources to support the operation’s activities

The strategic planning process should include an assessment of the servicing time necessary to recapture productioncosts and achieve required returns An understanding of this basic information is also critical to decisions to purchaseservicing rights, and should be incorporated into servicing hedging strategies

Comprehensive management information systems (MIS) are essential to a successful mortgage banking operation The bank’s systems should provide accurate, up-to-date information on all functional areas and should support thepreparation of accurate financial statements The MIS reports should be designed so that management can identifyand evaluate operating results and monitor primary sources of risk Management also should establish and maintainsystems for monitoring compliance with laws, regulations, and investor requirements

Internal and External Audit

Because of the variety of risks inherent in mortgage banking activities, internal auditors should review all aspects ofmortgage banking operations as part of the bank’s ongoing audit program Audits should assess compliance withbank policies or practices, investor criteria, federal and state laws, and regulatory issuances and guidelines Internalaudit staff should be independent and knowledgeable about mortgage banking activities They should report auditfindings and policy deviations directly to the board of directors or to the audit committee of the board

Examiners should assess the scope of internal and external audit coverage They should also review audit findingsand the effectiveness of management’s actions to correct deficiencies

Activities Associated with Mortgage Banking

Mortgage banking involves four major areas of activities: loan production, pipeline and warehouse management,secondary marketing, and servicing Each of these activities is normally performed in a separate unit or department ofthe bank or mortgage banking company

held-for-sale

investors

borrowers; remits payments to the permanent investor or security holder; handles contacts with borrowers aboutdelinquencies, assumptions, and escrow accounts; and pays real estate tax and insurance premiums as theybecome due

These activities commonly result in the creation of two unique assets: mortgage servicing rights (purchased and originated) and excess servicing fee receivables (ESFR) Evaluating the valuation techniques and accounting

principles associated with these assets is a key component of the examination of a mortgage banking operation

Loan Production

A bank involved in mortgage loan production should have policies and effective practices and procedures governingloan production activities At a minimum, those guidelines should address:

Types of Mortgage Loans

Mortgage banking operations deal primarily with two types of mortgage loans: government loans and conventionalloans

Government loans, which are either insured by the Federal Housing Administration (FHA) or guaranteed by theVeterans’ Administration (VA), carry maximum mortgage amounts and have strict underwriting standards Thesemortgages are commonly sold into pools that back GNMA securities

Conventional loans are those not directly insured or guaranteed by the U.S government Conventional loans are

further divided into conforming and nonconforming mortgages Conforming loans may be sold to the FHLMC or

FNMA (commonly referred to as government-sponsored enterprises or GSEs) which, in turn, securitize, package,and sell these loans to investors in the secondary market Conforming loans comply with agency loan size limitations,amortization periods, and underwriting guidelines FHLMC and FNMA securities are not backed by the full faith andcredit of the U.S government There is a widespread perception, however, that they carry an implicit governmentguarantee

Nonconforming loans are not eligible for purchase by a GSE, but can be sold in the secondary market as whole loans,

or can be pooled, securitized, and sold as private-label mortgage-backed securities The most common type ofnonconforming loan is a “jumbo loan” which carries a principal amount in excess of the ceiling established by theGSEs

Other nonconforming loans are largely nontraditional mortgage products created in response to customer preference,the interest rate environment, inflated or deflated property values, or competition Examples of these loans includemortgages with starting interest rates below market (“teaser rate”) that later increase; low/no documentation loans;graduated payment mortgages; negative amortization loans; reverse annuity mortgages; and no-equity mortgages Since nonconforming loans do not carry standardized features, the size of the market for these loans is considerablyless than that for conforming conventional loans These products may pose unique credit and price risks, and should

be supervised accordingly

When a borrower lacks sufficient equity to meet downpayment requirements, he or she may purchase private

mortgage insurance (PMI) to meet GSE and private investors’ underwriting guidelines The borrower purchasesmortgage insurance for FHA loans through the federal government Private companies offer mortgage insuranceproducts for conventional loans For conventional loans, mortgage insurance is generally required for loans with initialloan-to-value ratios of more than 80 percent

Sources of Mortgage Loans

Banks commonly create mortgage production through both retail (internal) and wholesale (external) sources

Retail sources for mortgage loans include bank-generated loan applications, brokered loans, and contacts with realestate agents and home builders Loans must be closed in the bank’s name to be considered retail originations Although originating retail loans allows a bank to maintain tighter controls over its products and affords the opportunity tocross-sell other bank products, the volume of loans generated in this manner may not consistently cover a bank’srelated fixed overhead costs A bank that engages in mortgage banking, therefore, may supplement its retail loanproduction volume with additional mortgages purchased from wholesale sources

Wholesale sources for loans include loans purchased from bank correspondents or other third-party sellers Thesemortgages close in the third party’s name and are subsequently sold to the bank

Banks commonly underwrite loans obtained through correspondents In some cases, the bank delegates the

underwriting function to the correspondent When this is the case, bank management should have systems to ensurethe correspondent is well-managed, financially sound, and providing high quality mortgages that meet prescribedunderwriting guidelines The quality of loans underwritten by correspondents should be closely monitored through post-purchase reviews, tests performed by the quality control unit, and portfolio management activities Monitoring the quality

of loans originated by the bank’s correspondent enables bank management to know if individual correspondents areproducing the quality of loans the bank expects If credit or documentation problems are discovered, the bank shouldtake appropriate action, which could include terminating its relationship with the correspondent

The wholesale production of mortgage loans allows banks to expand volume without increasing related fixed costs The wholesale business is highly competitive, however As a result, there may be periods during the business cyclewhen it is difficult for a bank to obtain required loan volume at an attractive price In addition, wholesale mortgages haveincreased potential for fraud if proper control systems are not in place

Underwriting Standards

To ensure loans made are eligible for sale to the secondary market, most lenders apply underwriting and

documentation standards that conform to those specified by the GSEs or private label issuers Although they will vary

by loan type, common underwriting procedures include:

credit history

Production Process

Mortgage loan production normally consists of four phases: origination, processing, underwriting, and closing Thehead of production should be responsible for supervising each of these areas and ensuring adherence to internal andexternal requirements In addition, that officer should be responsible for portfolio management

Origination

Originators are the sales staff of the mortgage banking unit Their primary role is the solicitation of applications fromprospective borrowers Normally, a significant portion of originators’ compensation takes the form of commissions Therefore, originators should not have authority to set or dominate the company’s loan pricing decisions, because thepotential conflict can create unacceptable reputation, market, and credit risks

Banks use many different ways to originate loans In addition to face-to-face customer contacts, many banks havetelemarketing and direct mailing units that provide additional ways to solicit applications

Processing

The employees of the processing unit, processors, verify information supplied by a mortgage applicant, such asincome, employment, and downpayment sources This unit is responsible for obtaining an appraisal of the financedproperty and acquiring preliminary title insurance The processing unit should use an automated processing system or

a system of checklists to ensure all required steps are completed and to maintain controls over loan documentation Processors must prepare files in a complete manner before the files are delivered to the underwriting unit If a creditpackage is incomplete, the underwriting process will be temporarily suspended, causing the bank to suffer

unnecessary delays and expense

Underwriting

The underwriting unit’s major function is to approve or deny loan applications Underwriters determine if a prospectiveborrower qualifies for the requested mortgage, and whether income and collateral coverage meet bank and investorrequirements This unit is responsible for reviewing appraisals for completeness, accuracy, and quality; evaluating aborrowers ability to close and repay the loan; determining if the property will be owner-occupied; checking the accuracy

of all calculations and disclosures; identifying any special loan requirements; and ensuring adherence to fair lending

The closing unit should perform a post-closing review of each loan file after closing, generally within ten days of closing This review ensures that the bank or its agent closed each loan according to the underwriter’s instructions and that alldocuments were properly executed Missing or inaccurate front-end documents identified in the post-closing reviewshould be tracked and obtained The unit should prepare reports that track these exceptions by the responsible loanclosers

Portfolio Management

The credit quality of loans that a mortgage bank originates affects the overall value of the mortgage servicing rights andthe bank’s cost of servicing those loans Because poor credit quality lowers the value of servicing rights and increasesthe underlying cost of performing servicing functions, it is essential that a mortgage bank effectively monitor the quality ofloans it originates

One common technique mortgage banks use to monitor loan quality is vintage analysis, which tracks delinquency,foreclosure, and loss ratios of similar products over comparable time periods The objective of vintage analysis is toidentify sources of credit quality problems early so that corrective measures can be taken Because mortgages do notreach peak delinquency levels until they have seasoned 30 to 48 months, tracking the payment performance ofseasoned loans over their entire term provides important information That information allows the bank to evaluate thequality of the unseasoned mortgages over comparable time periods and to forecast the impact that aging will have oncredit quality ratios

Mortgage bank management also should track key financial information initially received from the borrower andperform statistical analysis of borrower performance over time This information can be used to monitor trends andprovide insights into delinquency and foreclosure levels for each major product type Original loan-to-value ratios, andhousing and total debt coverage ratios are examples of essential financial statistics Management also should reviewsales and repurchase data on mortgage production to assess the quality of that activity

Production Quality Control

The Department of Housing and Urban Development (HUD), FHLMC, FNMA, GNMA, and most private investorsrequire the bank to have a quality control unit that independently assesses the quality of loans originated or purchased Quality control reviews may be performed internally or contracted to an outside vendor The quality control functiontests a sample of closed loans to verify that underwriting and closing procedures comply with bank policies or

practices, government regulations, and the requirements of investors and private mortgage insurers The unit confirmsproperty appraisal data and borrower employment and income information It also performs fraud prevention,

detection, and investigation functions

The quality control unit should be independent of the production function Management of quality control should not report

to an individual directly involved in the production of loans The unit also may report to the audit committee of the board,the mortgage company president, or the chief financial officer

The quality control unit should sample each month’s new production according to the investor’s sampling

requirements For the quality control reviews to be acceptable to HUD, FHLMC, FNMA, and GNMA, the sample must

be skewed toward higher risk loans (e.g., those with high loan-to-value ratios) The quality control unit also shouldreview loans that investors require the bank to repurchase, those that become delinquent within the first six months, andthose which may involve fraudulent actions against the bank

Reports issued by the quality control unit should be distributed to appropriate levels of management The reports shouldsummarize the work performed and overall conclusions regarding the quality of loan production and provide

loan-specific findings Quality control reports should normally be issued within 90 days of loan closing to help ensurethe underlying causes of deficiencies are resolved in a timely manner The quality control unit should require writtenresponses to significant deficiencies from management of the responsible unit Examiners should review severalquality control reports to determine the effectiveness of management’s actions to correct noted problems

To ensure fraud referrals are promptly investigated, the quality control unit should designate an individual or group ofindividuals responsible for detailing potential fraud exposure for the bank This individual or group should be

responsible for submitting criminal referrals to regulatory and law enforcement agencies as required by law, and forproviding fraud detection and prevention training to the sales staff, processors, underwriters, and collectors

Allowance for Loan and Lease Losses and Recourse Reserves

Banks involved in mortgage banking activities are required to establish three accounting reserves The allowance forloan and lease losses and recourse reserve are discussed here The foreclosure reserve is discussed later, underthe Servicing section of this introduction Each of the reserves should be separately established and analyzed foradequacy and not commingled

A bank’s allowance for loan and lease losses (ALLL) should adequately cover inherent loss in mortgages owned

by the bank This includes loans in both the permanent portfolio and warehouse account

The bank’s allowance policy, provision methodology, documentation, and quarterly evaluation of reserve adequacyshould comply with the requirements discussed in the “Allowance for Loan and Lease Losses” booklet of the

Comptroller’s Handbook

Banks may sell residential mortgage loans with recourse to FNMA and FHLMC and receive sales treatment

consistent with generally acceptable accounting principles (GAAP) To record these transactions as sales, the bank

must identify the expected losses on the mortgages with recourse and establish a recourse reserve to cover the

losses identified By establishing an appropriate recourse reserve, the bank can report the transactions as sales on itsquarterly Report of Condition and Income (call report) without regard to the recourse provision (For more information

on this accounting practice, see FAS 77.) Although these assets receive sales treatment for call report purposes, they

generally are still counted in risk-weighted assets in computing the bank’s risk-based capital ratio A bank must count

these assets for calculating risk-based capital unless it has not retained any significant risk of loss and the recourse

reserve recorded under FAS 77 is equal to the bank’s maximum exposure (See 12 CFR 3, Appendix A, Section 3,

footnote 14.)

The accounting treatment for sales of private-label mortgage-backed securities and nonconforming conventionalmortgages depends on the amount of risk retained The bank must account for the transaction as a financing (i.e.,borrowing) on the quarterly call report if its recourse exposure exceeds its total expected loss Only when the amount

of contractual recourse is less than or equal to the expected loss may the transaction be accounted for as a sale.Banks report most other loan sales on the quarterly Report of Condition and Income as a financing if the bank retainsany risk of loss.

Pipeline, Warehouse, and Hedging

Pipeline commitments have additional uncertainty because they are not closed loans A mortgage commitment issaid to be in the “pipeline” when an application is taken from a prospective borrower Commitments remain in thepipeline throughout the processing and underwriting period When the loan is closed, it is placed on the bank’s books in

a warehouse account where it remains until sold and delivered to an investor Conversely, loans that the bank plans toretain should be transferred to the permanent loan portfolio after loan closing

The loan commitment represents an option granted to the customer While commitments give customers the right toreceive the stated loan terms, they are not obligated to close the loan Changes in interest rates can significantly

influence the customer’s desire to execute this option

Warehouse loans are closed mortgages awaiting sale to a secondary market investor Uncertainty regarding thedelivery of a warehouse loan to an investor is limited to a determination of whether the loan meets investor underwriting,documentation, and operational guidelines As a result, 100 percent of warehouse loans are normally sold forward intothe secondary market

Hedging the price risk associated with loans awaiting sale and with commitments to fund loans is a key component of

a successful mortgage banking operation The overall objective of this function should be to manage the operation’sprice risk and minimize market losses, not to speculate on the direction of interest rate movements While somemarket risk positions are inevitable, they should always comply with board approved value-at-risk limits

Pipeline Management

When a consumer submits a loan application, a mortgage bank normally grants the consumer the option of “locking in”the rate at which the loan will close in the future The lock-in period commonly runs for up to 60 days without a fee Ifthe consumer decides not to lock-in at the current established rate, the loan is said to be “floating.” Locked in pipelinecommitments subject the bank to price risk, while floating rate commitments do not

Interest rate fluctuations affect mortgage pipeline activities Changes in rates influence the volume of loan applicationsthat the bank closes, the value of the pipeline commitments, and the value of commitments to sell mortgages in thesecondary market

If interest rates decline when a prospective borrower’s application is being processed, the applicant may decide toobtain a lower rate loan elsewhere before the loan can be closed For this reason, interest rate declines result in anincreased number of loans that do not close Loans in the pipeline that do not close are called “fallout.” The percentage

of mortgages that do not make it to closing is called the “fallout percentage.”

If the amount of fallout is so great that a bank is unable to meet its outstanding delivery commitments to investors, thebank may have to purchase needed loans in the secondary market at unfavorable prices or pay “pair-off fees” toliquidate its forward sale contract B a contract to commit to selll in the future B with an investor These pair-off fees equalthe impact of the market movement on the price of the loans covered under the contract

If, on the other hand, interest rates rise, fallout declines because customers have greater financial incentive to exercise

their option and close the loan When this occurs, a bank risks not having sold forward a sufficient dollar volume of

mortgages The interest rates on unhedged mortgages will be below market interest rates, causing the bank to incur a

loss when it sells the loans

Effective supervision of pipeline activities depends on accurate, detailed management information systems Systems

and pipeline modeling weaknesses, poor data quality, or inaccurate analysis could adversely impact business

decisions and results Reports should provide management with information needed to determine an appropriate

strategy for offsetting (hedging) the bank’s risk

Reporting systems should monitor the volume of loan applications that will continue through the various aspects of the

origination process, become marketable loans, and be delivered to investors The reports also should monitor the

status of delivery commitments to investors, the effectiveness of hedges, and historical fallout rates for each specific

loan category (e.g., 8 percent, 30-year fixed rate FHA loans or 7.50 percent, 15-year conventional loans) The bank

also may use a pipeline hedge model to estimate fallout volumes under various interest rate scenarios

Management also should develop prudent risk management policies and procedures, including earnings-at-risk parameters to guard against

adverse financial results (For appropriate risk management practices, see BC-277, Risk Management of Financial Derivatives.) Results of the

bank’s hedging practices should be quantified and reported to senior management regularly

Hedging the Pipeline Against Fallout

There are several approaches to protect, or hedge, the bank from fallout or unforeseen problems in the pipeline The

most common hedging technique is to sell forward the percentage of the pipeline that the bank expects to close For

example, if a bank anticipates 30 percent of applications to fall out, it will sell forward an amount equal to 70 percent of the

mortgage applications in the pipeline If the bank has estimated correctly and closes 70 percent of the loans, the

pipeline is completely hedged If the bank closes more or less than the 70 percent, however, it is exposed to price risk

Many banks use a combination of forward sales and options to offset price risk For example, if the bank anticipates

closing 80 percent of the loans in the pipeline under the best of circumstances but only 60 percent under a worst-case

scenario, it could sell forward an amount equal to 60 percent of the pipeline and purchase options to sell loans in the

market on 20 percent of the pipeline This method hedges the pipeline as long as 60 to 80 percent of the loans close

Using options to hedge pipeline risk is effective, but also more expensive than solely using forward sale contracts

Warehouse Management

A mortgage bank normally holds a loan in the warehouse account for no more than 90 days These loans are typically

already committed for delivery to an investor Loans remaining in the warehouse for a longer period may indicate

salability or documentation problems Unsalable mortgages should be transferred out of the warehouse and into the

bank’s permanent loan portfolio This transfer must be recorded at the lower of cost or market value (LOCOM)

The warehouse needs to be reconciled on an ongoing basis Normally, monthly reconcilements are sufficient and

provide a means of detecting funding or delivery errors

Hedging the Warehouse

Warehouse loans that are not adequately covered by forward sales commitments or other hedges expose the bank to

price risk If interest rates rise, the bank may have to sell the loans at a loss For this reason, banks should hedge

warehouse loans if the loans pose more than nominal risk exposure

Accounting for Pipeline Commitments and Warehouse Loans

Pipeline commitments and mortgages in the warehouse are classified as “held-for-sale” and, as stipulated in Statement

of Financial Accounting Standards (SFAS) No 65, should be accounted for at LOCOM Warehouse loans should bereflected on the balance sheet separately from the bank’s permanent portfolio of loans Warehouse loans are reported

on the quarterly Report of Condition on schedule RC-C Pipeline commitments should be accurately reported as acontingent liability on schedule RC-L, line 1e B other unused commitments

Secondary Marketing

A bank’s secondary marketing department, working with production management, is responsible for developing,pricing, selling, documenting, and delivering mortgage products to investors A bank must consistently demonstratereliable performance in underwriting, documenting, packaging, and delivering quality mortgage products to remain ingood standing with secondary market participants Poor performance of loans sold could lead to unfavorable prices forfuture sales or terminated relationships

Product Development

As discussed earlier, mortgage loans sold to government-sponsored agencies must meet each agency’s specificunderwriting and eligibility guidelines FHA and VA loans are eligible for sale into GNMA securities Conformingconventional loans (and certain FHA and VA loans) may be sold into FNMA and FHLMC securities Nonconforming(jumbo) conventional mortgages and mortgages which do not meet agency underwriting guidelines may be soldthrough private label securities or to private investors

The secondary marketing department should ensure that the loan products the bank intends to sell meet the guidelinesestablished by investors Before offering a new type of loan, the secondary marketing department should determine itsmarketability and consider the bank’s ability to price, deliver, and service the product The bank’s legal counsel andcompliance personnel also should review new products to determine if they comply with applicable laws and

discount point for an 8.50 percent, 30-year mortgage, to be priced at the market

During periods of aggressive competition, banks occasionally offer their mortgage products below applicable securityprices at a marketing loss (e.g., an 8.50 percent mortgage with no discount points) Alternatively, banks sometimesprice their mortgage products at a premium to the market (e.g., an 8.50 percent mortgage with two discount points) Management should give appropriate consideration to mortgage pricing to ensure it is consistent with the company’s

strategic plan and earnings objectives Although secondary marketing personnel should establish prices with inputfrom the head of production, originators should not be allowed to overly influence or dominate pricing decisions.

Recourse Options

A bank can choose to service loans for investors on either a recourse or non-recourse basis Servicing with recourseallows the bank to increase the price at which it sells loans Management should ensure that the bank is adequatelycompensated for the credit risk retained

Loans are serviced for FNMA under either “regular” or “special” servicing options With FNMA “regular” servicing,the bank retains all risk of loss from mortgagor default With FNMA “special” servicing, the bank only retains exposurefor normal representations and warranties (i.e., ensuring that the mortgage was properly underwritten according toestablished guidelines) FHLMC offers similar servicing options GNMA servicing carries no contractual recourse;however, in the event of mortgagor default, the servicer has exposure for principal loss (VA no bid), interest loss(FHA), and other nonreimbursable expenses incurred as part of the collection process

Regulatory accounting permits sales treatment for FNMA and FHLMC mortgages sold with recourse If the bankretains recourse on any other transactions, regulatory accounting prohibits sales treatment unless the expected lossexceeds the bank’s exposure The bank must establish appropriate reserves for all recourse exposure (Additionalinformation can be found earlier, under the Allowance for Loans and Lease Losses and Recourse Reserves section.)Guarantee Fee, Float, and Remittance Cycle

The amount of guarantee fees the bank pays agency and private guarantors is negotiable Guarantee fees are based

on the amount of risk assumed by the bank and the timing of cash flows (remittance cycle) paid to the investor Thelonger the guarantor holds the mortgage payments, the smaller the guarantee fee necessary to compensate them Investors have different requirements for accounting cutoff dates, payment schedules, and remittance dates

FNMA and FHLMC allow the seller (bank) to either “buy up” or “buy down” the guarantee fee These options providethe bank the flexibility for increasing or decreasing the amount of excess servicing If the bank buys up the guaranteefee (i.e., pays a higher fee to FNMA or FHLMC), it increases the amount of cash it receives in exchange for a smallerexcess servicing fee when the mortgages are sold When the bank buys down the guarantee fee, it receives lesscash from the sale in exchange for a larger excess servicing fee over the life of the underlying loans

Selling Mortgages

A bank can sell mortgages in the secondary market as an individual (whole) loan or as part of a pool of loans Poolsare usually made up of loans with similar characteristics, such as product type, underwriting terms, interest rate,original or remaining maturity, and payment frequency Banks that originate a substantial number of mortgage loansnormally pool them to sell because it produces a higher price and reduces transaction costs

Loans also may be “swapped” for pass-through certificates issued by investors (i.e., FHLMC) In this transaction, thebank gives up a portion of the interest income on the loan (generally 0.25 percent) in return for a more liquid asset andmore favorable risk-based capital treatment The bank retains servicing of the loans which back the certificate Banksthat engage in the swap program must follow generally accepted accounting principles and recognize loan origination

fees and direct origination costs over the life of the loan, as prescribed by SFAS No 91 (See SFAS No 91,

“Accounting for Nonrefundable Fees and Costs Associated with Originating and Acquiring Loans.”)

A bank’s relationship with an investor is usually based on a commitment from the investor to purchase a specific dollarvolume of loans A “master sales commitment” details the dollar amount and/or maturity of the obligation This

document also describes investor-mandated underwriting standards as well as delivery and mortgage servicingrequirements

Frequently, master sales commitments require mandatory delivery of loans This contractually obligates the bank todeliver a specific dollar volume of mortgages to the investor If the bank is unable to deliver the required volume withinthe specified commitment period, it must either purchase loans from other sources to deliver or pay the investor apair-off fee

Sales commitments also may involve “best efforts” (optional) delivery Under such commitments, the bank is notcontractually obligated to deliver a specific dollar volume of loans to the investor Mandatory delivery contracts

normally produce higher selling prices for the loans than best efforts contracts but contain more uncertainty and risk

Documentation and Delivery

To fulfill its delivery responsibilities, the banks must obtain all mortgage documents for its investors Front-end

documents are obtained before, or at, closing Post-closing documents such as mortgages, assignments, and titlepolicies must be recorded by local authorities or issued by the title company Post-closing documents may normally bereceived up to 120 days after closing

A good tracking system for document collection activities is necessary to ensure an effective process The systemshould identify the customer by name, the document missing, and the number of days since loan closing The bankshould diligently follow up on and obtain these documents Failure to obtain mortgage documents in a timely mannercan result in unnecessary financial and legal exposure for a bank

A bank that sells mortgages into GNMA securities must obtain a third party certification that all loan documents are onfile A bank’s affiliate or subsidiary company is eligible to certify the pools; however, in this arrangement GNMArequires the bank to have a separate trust department The file custodian issues the final pool certification after

verification that all documentation is complete If one loan in the pool is missing a single document, the entire pool maynot receive final certification

GNMA has established tolerance levels for the final certification, transfer, and recertification of mortgage pools

Examiners should be sure to reference current GNMA pool certification requirements If the seller exceeds theestablished limit, GNMA can require the seller to post a letter of credit to protect GNMA against potential loss FNMAand FHLMC do not have a specific monetary penalty in place, but do require an appropriate document collectionprocess

Sales contracts with private investors or purchasers of servicing normally require all documents to be obtained Common contract provisions include requirements that the seller repurchase defective mortgages, the buyer’s ability tohold back sales proceeds, and indemnification of the buyer from losses resulting from missing documents

Servicing

Servicing revenue is a primary source of income for many banks engaged in mortgage banking To be successful,the servicer must comply with investor requirements and applicable laws, have strong internal controls, and managecosts A servicing agreement between the bank and each investor describes the investor’s requirements for servicingits assets and the manner in which the servicer will be compensated Ultimately, if a bank fails to appropriately service

an investor’s portfolio, the servicing rights could be revoked without compensation

In addition to the contractual servicing fee paid by each investor, mortgage banks are compensated for their servicingactivities through: (1) income resulting from borrower/investor payment float; (2) ancillary income from late fees,commissions on optional insurance policies (credit life, accidental death, and disability), and miscellaneous fees; and(3) benefits of compensating balances from custodial funds

Effective cost management is essential for servicers Management should understand the company’s cost to serviceeach major type of loan in order to assess product profitability By understanding its servicing profitability, management

is better able to make informed strategic decisions regarding the portfolio Detailed information systems capable ofmeasuring and analyzing servicing costs are an essential part of this process

Cash management consists of collecting borrowers’ mortgage payments and depositing those funds into custodialaccounts The principal and interest portion of each payment is separated from the portion set aside for escrow items These custodial accounts require daily balancing and monthly reconciliation, control over disbursements, segregation

of administrative duties, and the deposit of funds into appropriate financial institutions

Investor accounting and reporting consists of performing various recordkeeping functions on behalf of investors Strong internal control systems must be in place to ensure accurate accounting and reporting The bank shouldreconcile each investor account monthly Outstanding reconciling items generally should be resolved within 30 days The bank should review the aging of unreconciled items on a regular basis and charge off uncollectible balances.Servicers process borrowers’ loan payments and remit principal and interest to investors according to the specifiedremittance schedule Most commonly, the schedule of borrowers’ payments (whether actually made or not)

determines the remittance schedule to the investor In other cases, investors are not paid until the servicer actuallyreceives payments from the homeowners

Investor accounting responsibilities vary according to the type of servicing program As an example, with GNMA Iservicing, the servicer remits principal and interest to individual security holders and is responsible for maintaining acurrent list of all security holders With GNMA II, FNMA, and FHLMC servicing programs, the servicer forwardsremittances to a central paying agent who remits payments to the security holders based upon a specified schedule.Some investors allow the servicer to purchase a loan from the pool when the loan reaches a certain level of

delinquency as outlined in the seller/servicer agreement This allows the servicer to reduce the costs of remittingprincipal and interest payments on behalf of a past-due borrower To maintain the government agency guarantee orinsurance, however, the servicer must continue to follow the agency’s servicing guidelines

Conversely, the bank should establish controls to prevent the purchase or removal of a loan from the pool beforeallowed by investor-established time frames Premature purchase or removal of a loan harms investors by

inappropriately reducing the outstanding balance of their portfolio

Servicing adjustable-rate mortgage loans requires special operating controls In particular, the bank should ensureinterest rate adjustments are properly performed and documented, and that customers are notified in accordance withinvestor guidelines

A servicer’s investor reporting responsibilities involve preparing monthly reports to investors on principal and interestcollections, delinquency rates, foreclosure actions, property inspections, chargeoffs, and OREO Servicers also reportinformation to consumer credit bureaus on the past-due status of a homeowner’s loan

Document custodianship consists of adequately safekeeping loan documents Original documents should be stored

in a secured and protected area such as a fireproof vault Copies of critical documents (i.e., a certified copy of the note)should be maintained in a separate location Servicers also should maintain an inventory log of documents held insafekeeping The log should identify documents which have been removed and by whom Some investors requirethe servicer to employ a third-party custodian to safeguard loan documents In such cases, the servicer is responsiblefor timely delivery of documents to the custodian

Escrow account administration consists of collecting and holding borrower funds in escrow to pay real estate taxes,hazard insurance premiums, and property assessments The escrow account administration unit sets up the account,credits the account for the tax and insurance funds received as part of the borrower’s monthly mortgage payment,makes timely payments of a borrower’s obligations, analyzes the account balance in relation to anticipated paymentsannually, and reports the account balance to the borrower annually If a borrower’s escrow account has a surplus orshortage, the unit makes a lump-sum reimbursement or charge to the borrower, or adjusts the amount of the

homeowner’s monthly mortgage payment accordingly

A servicer may collect and hold escrow funds on behalf of each borrower only up to the limits established by 12 U.S.C

2609, the Real Estate Settlement Procedures Act (RESPA), i.e., up to the amount required to make expected

payments over the next 12 months plus an additional one-sixth of that amount This limit applies to funds collected atclosing as well as those collected throughout the life of the loan State laws may also prescribe escrow accountbalance limits and, in some cases, require the servicer to pay interest on escrow balances

Collection consists of obtaining payment on delinquent loans by sending written delinquency notices to borrowers,making telephone calls and arranging face-to-face contacts, conducting property inspections, and executing foreclosureactions

The collection unit should closely follow investor requirements on the timing and manner of collection activities

Collection personnel should document each step in the collection process including actions taken, the date of eachaction, success in contacting the borrower, and the commitment received from the overdue borrower

Collection activities must comply with the Fair Debt Collection Practices Act (15 U.S.C 1692) Among other things, thislaw defines from whom a debt collector may gather information on a consumer, the type of information that may becollected, and the acceptable forms of communicating with the consumer and other parties The servicer must alsofollow state laws pertaining to collection and foreclosure actions

In some cases a collection unit may enter into a short-term forbearance arrangement with a delinquent borrower beforebeginning a foreclosure action For example, a servicer may permit the borrower to defer payments, follow an

alternative repayment plan, or execute a deed-in-lieu of foreclosure Management should have information systemsadequate to analyze forbearance activities The collections unit also should soundly derive and thoroughly documentthe reason for each forbearance arrangement and obtain investor approval, if necessary.

A servicer advances funds and incurs costs on behalf of investors during the collection process and during the timeforeclosed property is administered as other real estate owned An account receivable is normally established toaccount for these investor advances The investor subsequently reimburses the servicer for much of the funds

advanced and costs incurred The servicer will still likely incur some of the costs associated with collecting a

delinquent loan, even for mortgages serviced with no contractual recourse One example of this arises in a VA bid” action If the loss expected to be recognized by the VA following a foreclosure is greater than the amount of the VAguarantee, the VA may elect to pay the full amount of its guarantee to the servicer and transfer title to the property Theservicer is left to administer and dispose of the property, commonly at a substantial loss Other noteworthy collectioncosts include nonreimbursed interest advances on FHA loans and expenses above those considered normal andcustomary by investors

“no-The bank should establish a “foreclosure reserve” to provide for uncollectible investor advances Using historicalcollection and disposal costs for each major product type as a guide, the foreclosure reserve should adequately coverexpected losses Chargeoffs, recoveries, and provision expenses should be recognized through the foreclosurereserve

Other real estate owned (OREO) administration consists of managing and disposing of foreclosed properties Somemortgage servicing agreements require the servicer to take legal title to OREO; for example, loans sold with recourse

or a VA no-bid loan In these cases, the investor transfers property title to the servicer following the foreclosure action

If the bank has or will obtain legal title to the property, management must follow the terms and conditions under which anational bank may hold real estate and other real estate owned, as specified in 12 U.S.C 29 and 12 CFR 34 When thebank bears primary loss exposure for a serviced loan, management must follow the instructions for preparation of theReport of Condition regarding loan loss recognition and OREO reporting

Servicing agreements may also include provisions involving OREO that merely require the servicer to performadministrative duties as agent for the investor For example, the servicer may be required to secure and protect theproperty, conduct inspections on a regular basis, obtain a current appraisal, and market the property

Loan setup and payoff consists of inputting information into the automated servicing system and processing loanpayoffs The loan setup unit inputs information regarding the borrower, the type of loan and repayment terms, and theinvestor Appropriate servicing of the loan requires the setup unit to input data accurately and in a timely manner(normally within 15 days of loan closing, or moderately longer for acquired loans) The setup unit, or some otherrelated unit, normally sends the borrower a letter which introduces the company’s services and includes the firstpayment coupon This “welcome letter” helps to establish positive customer relations and to reduce the volume ofloans with “first payment default” (which may cause an investor to refuse the loan) Given the large volume of inputs,loan setup is an expensive process for many servicers Commonly, the cost of loan setup exceeds all or most of thefirst year’s servicing revenue

The payoff unit is responsible for processing loan payoffs, including recording the mortgage satisfaction and returningthe original note to the borrower Failure to process the mortgage satisfaction in accordance with state laws may result

in monetary fines

If a loan pays in full during the month, some investors require the servicer to remit a full month’s interest even thoughthe borrower only paid interest through the payoff date This interest expense can significantly impact servicing costs inperiods of high payoffs The examiner should assess the bank’s efforts to minimize this interest expense

Customer service creates and maintains a positive relationship with borrowers The customer service unit

researches and answers customer questions Customer service commonly tracks customer complaints and

ensures they are satisfactorily addressed Customer service efforts are especially important before and after servicingportfolio purchases or sales, or during periods of high business activity

Other servicing arrangements that are important to mortgage servicing include data processing systems and outsidevendors and subservicers To assist in tracking servicing-related information, the servicer should employ an adequatedata processing system A bank servicer should have thorough controls and audit coverage in place to ensure theintegrity of the information

A servicer may employ outside vendors and subservicers to perform various servicing tasks such as making realestate tax and insurance payments, performing lock-box services, conducting property inspections, and performingcustodial duties for loan documents In such situations, management should regularly assess the quality of eachvendor’s work and annually evaluate the vendor’s financial strength

Servicing Quality Control

Banks are encouraged to have a quality control function that independently reviews the work performed by eachservicing function The quality control unit should test a representative sample of transactions, report its findings toappropriate levels of management, and require written responses for significant findings

Mortgage Servicing Assets

Mortgage banking activities commonly result in the creation of mortgage servicing rights (purchased and originated)and excess servicing fee receivables (ESFR) assets Purchased mortgage servicing rights (PMSR) and originatedmortgage servicing rights (OMSR) represent the cost of acquiring the rights to service loans for others

The Financial Accounting Standards Board adopted Statement of Financial Accounting Standards No 122 (SFAS122) allowing originated mortgage servicing rights (OMSR) as assets on a bank’s balance sheet Previously, bankscould not record OMSR as an asset Efforts are currently underway to consider revising current regulatory capital andreporting treatment of OMSR Once a final decision is made on regulatory treatment for OMSR, these procedures will

be revised to incorporate any changes

Mortgage Servicing Rights

Methods of Acquiring PMSR and OMSR Assets

A bank may build a mortgage servicing portfolio by purchasing the right to service a group of loans for an investor Abank can purchase the right to service mortgages and create PMSR in any of three ways: bulk acquisitions,

production flow activities, or business combinations OMSR can be acquired through the bank’s retail loan productionactivities Both originated and purchased mortgage servicing rights are reported on the bank’s quarterly Report ofCondition on schedule RC-M

In a bulk acquisition transaction, a mortgage bank purchases the servicing rights only, leaving ownership of the

underlying mortgages or securities to the investor A bank may capitalize the cost of purchasing these servicing rights,but the amount capitalized should not exceed the assets’ purchase price or fair value

Before proceeding with each bulk acquisition, the bank should conduct a due diligence review of the servicing portfolio it

is considering acquiring The review should document and analyze all of the characteristics of the portfolio In addition,the reviewer’s analysis of the economic value of the servicing rights should be documented in writing, including thevaluation assumptions used The bank should keep records of due diligence reviews for every purchased portfolio

Production flow activities are transactions in which the bank purchases both newly underwritten mortgage loans andthe rights to service those loans The bank must allocate the purchase price between loans and acquired servicingrights if it has a definitive plan to sell (or securitize) the loans at the time of the purchase transaction To qualify as adefinitive plan, the bank must have formally committed to sell (or securitize) the loans before it completes the purchase,obtain a commitment to sell the mortgages to an investor within a reasonable time frame after the purchase (usuallywithin 30 days), or, before the purchase date, make a commitment to deliver the mortgage loans for securitization Theplan to sell (or securitize) the loans should include estimates of the purchase price and selling price of the mortgages

If the bank does not have a definitive plan to sell or securitize the mortgages, PMSR cannot be booked at the purchasedate Instead, the cost of acquiring the servicing rights is included as part of the overall cost of purchasing the

mortgages

In a business combination, the bank records PMSR and OMSR formerly held by the entity acquired If the

business combination is a purchase transaction, the purchasing bank should record as PMSR the existing mortgageservicing rights of the acquired bank at fair value The purchasing bank also must book the fair value of uncapitalizedservicing rights associated with mortgages that the acquired bank originated and sold When determining the fair value

of PMSR, the purchasing bank should consider the market prices currently being paid for servicing rights similar tothose acquired

If market prices are unavailable, SFAS 65, as amended by SFAS 122, requires the purchasing bank to use alternativemethods to value the servicing rights (i.e., a discounted cash flow method using a market value discount rate, option-pricing models, matrix pricing, option-adjusted spread models, and other fundamental analysis) When using thediscounted cash flow method, the purchasing bank should estimate the net servicing income it expects to earn over thepredicted life of the underlying mortgages In arriving at the projected net servicing income, the purchasing bank shoulddeduct all related expenses that are predicted to occur over the same period The purchasing bank should thendiscount the estimated future net income stream using a market yield to arrive at the fair value of the servicing rights PMSR cannot be recorded for more than its purchase price or present value

If the business combination is accounted for as a pooling of interests, the purchasing bank may not book PMSR on theloans the acquired bank originated and sold, but did not capitalize Under accounting rules for pooling of interest, theassets and liabilities of the two banks are merely added together at their current book values The purchasing bankcannot make adjustments to reflect fair value of the acquired assets

Retail Production consists of activities in which the bank, through its branch network or production units, originatesnew mortgage loans that close in the bank’s name or the name of one of its subsidiaries If the bank has a definitiveplan to sell (or securitize) the loans at the time they are originated, it must capitalize a portion of the origination cost thatrelates to the originated servicing rights (OMSR) The amount capitalized should be based on the relative fair values ofthe mortgage loans and the servicing rights Costs other than direct loan origination costs must be charged to expensewhen incurred; therefore, only direct loan origination costs are deferred as part of the cost of the loans When the loansare purchased, however, the cost may include both the seller’s indirect and direct costs Thus, all other things beingthe same, the costs capitalized for retail originated loans generally are less than the those for purchased loans and thegain generally will be greater

If the bank intends to hold the mortgages in its loan portfolio, the entire origination cost is allocated to the mortgage loans

and no cost is allocated to mortgage servicing rights.

Documentation and Recordkeeping

A bank should have adequate recordkeeping systems in place to monitor its origination and production flow activities aswell as its bulk acquisitions These records should support and account for the value assigned to each PMSR andOMSR asset when it was initially booked The system should also monitor prepayment and other changes in valuation

When a bank records PMSR as a result of a business combination purchase transaction, the acquiring bank shoulddocument the methodology used to compute the fair value of the acquired servicing assets For a pooling of interests,the acquiring bank should document the book value of the acquired bank’s existing mortgage servicing rights as of thepooling date The acquiring bank also should document the assumptions the it used to arrive at that value

Valuation and Amortization

The value of a servicing asset is based on its expected future cash flows To value servicing rights, a bank estimatesthe net servicing income it will earn from the servicing activities, and discounts that income stream to its present valueusing a discount rate that reflects the riskiness (i.e., uncertainty) of the cash flows

Most mortgage loans are repaid well before contractual maturity, as homeowners move, refinance, or simply pay theloan ahead of schedule To estimate the income it will receive from servicing the loans, however, a bank must projectthe level of servicing fees it can expect from the loan pool as individual loans prepay over time The prepayment speed

is a key component in a valuation model, and represents the annual rate at which borrowers are forecast to prepaytheir mortgage loan principal Common prepayment speed measures used by the industry include Public SecuritiesAssociation (PSA), Conditional Prepayment Rate (CPR), and Single Monthly Mortality (SMM) (For definitions of

these terms, see the Glossary.)

A prepayment model provides an estimate of contractual income from loan servicing Total servicing income includes:

Servicing expense items should incorporate direct servicing costs and appropriate allocations of other costs

Estimated future servicing costs may be determined based on additional (or incremental) costs that the bank will incur

as a result of adding additional loans to its servicing portfolio

Once a bank has estimated the net servicing income (expected servicing income less expected servicing expenses) itwill receive for servicing the pool, it must discount these cash flows to their present value by using a market discount

rate appropriate for mortgage servicing rights (MSRs) The discount rate used should equal the required rate of returnfor an asset with similar risk It should consider an investor’s required return for assets with similar cash flow risks,such as mortgage-backed interest-only strips for similar underlying mortgages The discount rate also should

consider the risk premium for the uncertainties specifically associated with servicing operations (e.g., possible changes

in future servicing costs, ancillary income, and earnings on escrow accounts) The fair value of the servicing rights isthe present value (using an appropriate market discount rate) of the expected net servicing income

When valuing mortgage servicing rights, banks should use a prepayment speed based on long-term prepaymentestimates for the underlying mortgages Prepayment speeds should be realistic and substantiated by independentsources (Examples of independent sources are Bloomberg, Telerate, and Knight Ridder.) Banks with substantialservicing assets should track their own prepayment experience for different pools and types of mortgages to validateprepayment assumptions they use in valuation models If a bank’s servicing portfolio consistently experiences

prepayment rates that differ from industry experience for similar pools, because of regional or other factors, the bankmay use customized prepayment speeds If the bank uses customized prepayment speeds, those speeds must beboth well supported and properly documented

If a bank’s estimate of fair values is not based on appropriate market discount rates and realistic prepayment speeds,MSR values will not be supportable If a slower than expected prepayment speed, or an inappropriately low discountrate, is used, the capitalized book value of the MSR assets will be inflated Employing a faster prepayment speedand/or a higher than market discount rate will have the opposite effect

Initial Recordation of Servicing

A bank that purchases or originates mortgage loans with a definitive plan to sell or securitize the loans, and retain theservicing rights, must allocate the cost of the mortgage loans between the loans and the servicing rights The allocatedcost must be based on the relative fair value at the date of purchase or origination, if it is practicable to estimate those fairvalues The allocation shall be based on the assumption that a normal servicing fee will be retained and the remainingcash flows will be sold or securitized

For example, if the cost to purchase or originate a loan is $99,000, and the fair value of the loan (without the servicingrights) and the servicing rights are $98,000 and $2,000 respectively (total $100,000), then 98 percent of the cost isallocated to the loan and 2 percent is allocated to the servicing rights Therefore, the loan and rights would be valued at

$97,020 and $1,980 respectively, as shown below:

Servicing rights $1,980 ($99,000 x 02)

A bank that does not have a definitive plan to sell or securitize at the time of purchase or origination, but later sells orsecuritizes the mortgage loans and retains the servicing, must capitalize the servicing at the date of sale (or

securitization) The cost allocated to servicing, however, must be based on relative fair values of the loans and

servicing rights at the date of sale or securitization

When allocating the costs, a bank must consider quoted market prices or market prices currently available for

servicing similar to that purchased or originated If similar servicing pools are not available, a bank may use alternativemethods, such as a discounted cash flow method (described above) or other appropriate methodology, to estimate thefair value

When estimating fair value, a bank should consider the expected life of the anticipated future servicing revenue stream,not the contractual maturity of the loans being serviced Because loans prepay, the life of the revenue stream will be

less than the contractual maturity of the serviced mortgages A bank should incorporate assumptions that buyerswould use in their estimate of future servicing income and expense.

Amortization of MSRs

Banks must amortize PMSR and OMSR in proportion to, and over the period of, the net servicing income Forexample, if the bank expects to receive 10 percent of its estimated net servicing income in the first year, 10 percent ofthe purchase price of the servicing rights should be amortized in the first year

For each pool of serviced loans, net servicing income will be greatest in the earlier years of the mortgages and willdecline as borrowers pay down the principal on their loans Because of this, a bank should use an acceleratedamortization method for PMSR and OMSR As indicated in the instructions for the Report of Condition, the maximumperiod for amortizing PMSR and OMSR is 15 years If unexpected changes in net servicing income occur, or areexpected to occur because of prepayments or other changes, the bank must adjust its amortization rate accordingly

Impairment Analysis

Banks should assess the characteristics of the underlying mortgage loans and choose one or more of the appropriatepredominate risk characteristics (e.g., loan type, such as the various conventional or government-guaranteed orinsured mortgage loans, adjustable-rate or fixed-rate mortgage loans; size of loan; note rate; date of origination; term;and geographical location) to stratify (group) the costs of PMSR and OMSR PMSR and OMSR may be combinedfor purposes of developing appropriate risk strata Banks may apply previous accounting policies for stratifying

mortgage servicing rights that were capitalized prior to the adoption of SFAS 122

Each quarter, a bank must evaluate its servicing portfolio for declines in value (impairment) Impairment should bemeasured by stratum on a fair value basis Banks record impairment by establishing a valuation reserve for eachstratum in which the combined book value of the mortgage servicing rights (PMSR and OMSR) exceeds fair value

To the extent possible, banks should base the quarterly valuation on market quotes from active markets If marketprices are unavailable, the bank should use the best information available in the circumstances including, for example,prices of similar assets, discounted cash flow calculations, and various other fair value valuation techniques

Estimates of fair value of each stratum selected should incorporate market participants’ assumptions including market(current) discount rates, prepayment speeds, and valuation assumptions unique to each underlying loan pool Loanpools that have similar risk characteristics can be combined to measure fair values within each stratum Unanticipatedprepayments, a change in future expected prepayments, loan delinquencies, defaults, and certain other events mayaffect the fair value of any particular stratum

To appropriately assess impairment, banks generally will need to perform a detailed analysis of the loan pools thatunderlie each stratum The detailed analysis may include assessments based on product, term, interest rate, andother relevant characteristics (e.g., FNMA,15-year, weighted average coupon 9.50 percent)

To determine impairment of a particular stratum, banks may combine the unimpaired servicing pools with impairedpools within each stratum If the impairment analysis reveals that current book value of a stratum (net of amortization) isgreater than fair value, the bank must increase the valuation allowance for that stratum by the difference The fair value

of mortgage servicing rights that have not been capitalized shall not be used in the evaluation of impairment

When determining if the value of a stratum is impaired, a bank may not offset losses in one impaired stratum against

gains (if any) in another Valuation allowances for an individual stratum may be reduced or eliminated if values recover;however, it is never appropriate to write up the unamortized book value of a stratum on a bank’s books.

Management should document their quarterly reviews for impairment The documentation for each stratum shouldinclude, at a minimum, the original and current book values of the servicing rights, dates acquired, the original andcurrent balances of the underlying mortgages, loan characteristics (e.g., GNMA, 30-year, weighted average coupon

10 percent, 200 PSA), and the remaining absolute and discounted net cash flows The bank should maintain thisinformation for individual bulk acquisitions as well as for business combinations For origination and production flowactivities, the bank, at a minimum, should maintain this information by product type and by month Documentation of thequarterly analysis for impairment also should include a summary rollforward of the activity in the valuation allowancesfor each individual stratum during the period, including any additions charged, reductions credited to operations, anddirect write downs charged against the allowance

Excess Servicing Fee Receivables

Excess servicing fee receivables (ESFR) represent the present value of servicing revenue above the contractualservicing rate (normal servicing fee) ESFR can be recorded for mortgages originated by the bank and for thoseobtained through production flow activities and subsequently sold

Recording ESFR

The interest rate paid by a borrower on a mortgage loan ordinarily is greater than the rate “passed through” to the owner

of the loans (the pass-through rate) If the rate paid by the borrower minus the pass-through rate is positive and

exceeds the sum of the normal servicing fee plus the applicable guarantee fee, a bank can capitalize an ESFR asset For example, consider a 30-year, fixed rate, conventional loan If the loan rate is 9 percent, the pass through rate is 8.5percent, the normal servicing fee is 0.25 percent (25 basis points), and the guarantee fee is 0.21 percent (21 basispoints), then the excess servicing fee is 0.04 percent (4 basis points) The ESFR asset is reported on the bank’squarterly Report of Condition on schedule RC-F, line 3

According to SFAS 65 and regulatory accounting rules, if the actual servicing fee is less than the normal servicing fee,the sales price of the loans associated with a particular ESFR asset must be adjusted to provide for the recognition of anormal servicing fee in each subsequent year The amount of the adjustment is the difference between the actual salesprice and the estimated sales price that would have been obtained if a normal servicing fee rate had been specified (The amount of this adjustment is the present value of the future excess servicing-related cash flows described in thepreceding paragraph.) In addition, if normal servicing fees are expected to be less than estimated servicing costs overthe estimated life of the mortgage loans, the expected loss on servicing shall be accrued at that date

The ESFR asset results in a larger gain or smaller loss on the sale of loans This is in addition to any cash gain or lossfrom the sale The recognized gain cannot exceed the gain that would have been realized for the same sale withservicing released In addition, if the applicable guarantee fee and normal servicing fee exceed the interest rate

difference between the weighted average coupon (WAC) and the pass-through rate, the bank must record a loss

Documentation and Recordkeeping

A bank should have recordkeeping systems that support and account for the initial and ongoing values assigned toESFR assets For each sale of ESFR-related mortgages, the bank should maintain a file that documents the

assumptions used to value and record the corresponding ESFR asset

In addition, the bank should have a system that tracks actual payment experience for individual mortgage pools The

system should also contain information on the original and current principal balance for each pool; original and currentbook values of ESFR assets; and the discount rate, prepayment speed, and excess servicing fee used to calculate thepresent value of the excess servicing fee receivable for each pool The bank should use this information when

preparing the quarterly ESFR impairment analysis The current servicing fee can change over time if mortgages withdifferent note rates are sold into the same security

Because ESFR assets represent earnings and capital to the bank when they are recognized, overly optimistic orunreasonable assumptions could result in overstated earnings and capital A bank should have satisfactory policies,procedures, and control systems in place to ensure that ESFR are realistically valued and that the book value is basedupon prudent assumptions

Valuation and Amortization

The initial book value of each ESFR asset should be based upon cash flow calculations that use the expected lives ofthe underlying mortgages not the contractual maturity of the loans This is because prepayments will shorten thecontractual maturities of the underlying mortgages In addition, normal amortization of loan principal and prepaymentswill cause this cash flow to steadily decrease over time

A bank should use a market rate to discount the expected cash flow stream related to each ESFR asset in order todetermine its present value The discount rate should be an appropriate long-term rate that considers the risks

associated with ESFR As a guideline to determine if the discount rate for an ESFR asset is appropriate, examiners

should remember that risks associated with ESFR correspond to those of mortgage-backed interest-only securities.These ESFR assets frequently have required returns approximately 200 basis points in excess of the underlyingmortgage interest rate Higher or lower discount rates may be appropriate, but should also be adequately supported The bank’s cost of funds rate, a Treasury security rate, or the mortgage note rate are not appropriate discount ratesbecause these rates do not reflect the underlying risk of the ESFR asset

If cash flow calculations are not based on appropriate long-term rates, ESFR book values will not be supportable If aslower than expected prepayment speed or an inappropriately low discount rate is used, the capitalized book value ofthe ESFR asset will be inflated Employing a faster prepayment speed and/or a higher-than-market discount rate hasthe opposite effect on book value, e.g., it underestimates the value of the asset Banks should use prepayment speedswhich are realistic and supportable

A bank should use either the interest method or the level yield method to amortize the ESFR associated with each loanpool As was the case with the initial book value calculations, the amortization period for each ESFR asset should bebased on the projected lives of the underlying mortgages, not the contractual maturities of the loans At a minimum, thebank should establish different amortization periods for distinctly different mortgage products (for example, 15-year fixed,30-year fixed, and adjustable-rate mortgages)

The following is a formula for determining ESFR:

Principal Balance of Mortgage Pool X Excess Servicing Fee X Conversion Factor = ESFR

The excess servicing fee is the servicing fee remaining after subtracting the pass-through rate, guarantee fee, and thenormal servicing fee from the weighted average note rate of the mortgage pool The conversion factor is a

representation of the prepayment speed, discount rate, and contractual maturity of the mortgages It quantifies thepresent value equivalent number of years of cash flow The bank’s conversion factor can be compared to FNMA andFHLMC guarantee fee buy-up and buy-down schedules to evaluate its reasonableness

Impairment Analysis

Management must conduct a pool-by-pool review of the value of ESFR at least quarterly and adjust the book value ofthe ESFR asset, if necessary The bank should thoroughly document each impairment review

If unanticipated prepayments, changes in expected future prepayments, or other events occur that reduce the amount

of expected future excess servicing fee income, a bank must write down the asset by the amount by which the asset’sbook value exceeds the discounted amount of future excess servicing fee income In the future, if changes in

prepayment speeds are considered permanent, the bank should also increase the amortization rate for these assets The discount rate used in the impairment analysis should be the rate used when the asset was created The discountrate should remain constant throughout the life of the asset

When the true prepayment experience for a pool of loans is slower than original estimates, the value of ESFR assetsassociated with that pool will exceed its book value Although a bank may not write up the book value of these ESFRassets, it can slow down the amortization rate

Hedging Mortgage Servicing Assets

A bank should operate under a comprehensive interest rate risk management policy approved by its board of

directors At a minimum, the policy should address hedging objectives, acceptable hedge instruments, accountingtreatment, position limits, loss (earnings-at-risk) limits, personnel authorized to engage in hedging activities, and

required MIS reports The board and senior management should receive periodic reports summarizing the bank’shedging activities

Risk Management

Servicing rights provide high returns for a bank if properly priced, but contain substantial risk An effective risk

management program can reduce the volatility of returns

Falling interest rates can quickly result in negative returns During periods of falling interest rates, prepayments

accelerate and reduce the value of originated and purchased mortgage servicing rights Protecting this revenuestream through effective hedging is essential for the bank’s uninterrupted success Insurance can protect the bankagainst losses

During periods of rising interest rates, servicing rights on fixed-rate products will increase in value Their appreciationwill compensate for the cost of insurance (hedging)

Risk management policies should address risks associated with prepayments Since the value of mortgage servicingassets declines as prepayment speeds on the underlying loans increase, a bank with significant holdings of theseassets should, at a minimum, have a method for protecting against catastrophic losses that could result from

unexpected prepayments Responsible parties should be able to demonstrate to senior bank management, regulators,and accountants how the bank analyzes, limits, and hedges this prepayment exposure Failure to adequately identifyand appropriately limit the bank’s prepayment risk may be viewed as an unsafe and unsound banking practice

To substantiate the validity of hedge positions, management also should regularly perform documented analyses ofhow closely the hedge instrument and the asset being hedged have correlated Examiners should determine if thebank’s hedging activities have exposed it to basis risk Basis risk occurs when the value of the hedge instrument doesnot move in perfect tandem with the item being hedged Any disparity can result in different movements in the market

value of each For example, using Treasury-based products to hedge mortgage servicing assets can create basisrisk Examiners should review how management establishes hedge ratios and monitors basis risk.

The prepayment swap is a symmetrical hedge If the prepayment speed accelerates, the bank receives payment

from the hedge dealer; if prepayments slow down, the bank makes payments to the dealer In a faster prepaymentenvironment, the prepayment swap is designed to create increasing hedge-related cash flow to the bank as the cashflow of the servicing portfolio is declining In a lower-than-projected prepayment climate, the bank forfeits some of theincrease in servicing portfolio value that accrues from declining prepayments

A principal cap preserves the book value of the servicing portfolio and, thereby, stabilizes the yield on the servicing

asset A principal cap is an asymmetrical hedge: the bank receives payments if prepayment speeds accelerate, butdoes not make payments if they diminish The bank’s potential loss on the hedge is limited to the fixed premium paidthe dealer

A revenue cap is also an asymmetrical hedge Its objective is to stabilize the revenue stream of the servicing asset

over the life of the hedge

Whether management uses the hedges described above, other new products likely to enter the market, or instrumentsdevised internally, examiners should analyze closely the appropriateness, correlation, and effectiveness of hedgingstrategies Regardless of the approach, the overall objective should be effective risk management The bank shouldview hedging activities as insurance to protect against losses, not as a source of profits

Accelerated amortization An accounting technique in which the larger portion of the asset’s book value is written off

in the early years of the asset’s expected life

Accelerated remittance cycle (ARC). An option whereby an entity selling and/or servicing mortgages to/for theFederal Home Loan Mortgage Corporation reduces the guarantee fee it pays by paying principal and interest paymentsearly and shortening the monthly remittance delay

Accident and health premium. A payment by a borrower to ensure that mortgage payments continue to be paid ifthe borrower becomes disabled or ill

Acquisition cost. In a Federal Housing Administration transaction, the price the borrower pays for the property plusany closing, repair, and financing costs (except discounts in other than a refinancing transaction) Acquisition costs donot include prepaid discounts in a purchase transaction, mortgage insurance premiums, or similar add-on costs

Adjustable-rate mortgage (ARM) also called a variable-rate mortgage (VRM) A mortgage loan that allows a

lender to adjust periodically the interest rate in accordance with a specified index agreed to at the inception of the loan

Amortization. The process of paying off a loan by gradually reducing the balance through a series of installmentpayments, or the process of writing off mortgage servicing assets on a bank’s balance sheet

Annual mortgage statement. A report, prepared by the lender or servicing agent, for a mortgagor that states theamount of taxes, insurance, and interest that were paid during the year, and the outstanding principal balance

Balloon mortgage. A mortgage for which the periodic installments of principal and interest do not fully amortize theloan The balance of the mortgage is due in a lump sum (balloon payment) at the end of the term

Best efforts. See Optional delivery commitment.

Bulk acquisition. Purchase of the servicing rights associated with a group of mortgages Ownership of the

underlying mortgages is not affected by the transaction See also Purchased mortgage servicing rights.

Buy-down guarantee. See Guarantee fee buy-down.

Buy-down mortgage. A mortgage in which a lender accepts a below-market interest rate in return for an interest ratesubsidy paid as additional discount points by the builder, seller, or buyer

Buy-up guarantee. See Guarantee fee buy-up.

Cap (interest rate). In an adjustable-rate mortgage, a limit on the amount the interest rate may increase per period

and/or over the life of the loan See also Floor.

Capitalize. Converting a series of anticipated cash flows into present value by discounting them at an established rate

of return

Capitalized value. The present value of a set of future cash flows

Certificate of reasonable value (CRV). A document issued by the Veterans Administration (VA) that establishes amaximum value and loan amount for a VA-guaranteed mortgage.

Closing. Consummation of a mortgage transaction at which the note and other legal documents are signed and theloan proceeds are disbursed

Closing costs. Fees paid to effect the closing of a mortgage Common closing costs include origination fees, discountpoints, title insurance fees, survey fees, appraisal fees, and attorney’s fees

Closing statement. A financial disclosure giving an account of all funds received and expected at closing, includingescrow deposits for taxes, hazard insurance, and mortgage insurance All federally insured or guaranteed and mostconventionally financed loans use a uniform closing statement called the HUD-1

Commitment (lender/borrower). An agreement, often in writing, between a lender and a borrower to lend money at afuture date or for a specified time period subject to specified conditions

Commitment (seller/investor). A written agreement between a seller of loans and an investor to sell and buy

mortgages under specified terms for a specified period of time

Commitment fee (lender/borrower). A fee paid by a potential borrower to the potential lender for the lender’s promise

to lend money at a specified date in the future, or for a specified period of time and under specified terms

Commitment fee (seller/investor). A fee paid by the loan seller to the investor in return for the investor’s promise topurchase a loan or a package of loans at an agreed-upon-price at a future date

Computerized loan origination system (CLO). An electronic system that furnishes subscribers with the latest data

on available loan programs at a variety of lending institutions Some CLOs offer mortgage information services and canpre-qualify borrowers, process loan applications, underwrite loans, and make a commitment of funds

Conditional prepayment rate (CPR). A standard of measurement of the projected annual rate of prepayment for amortgage loan or pool of loans Although the standard CPR is 6 percent per year, it can be quoted at any percentage For example, a 10.5 percent CPR assumes that 10.5 percent of the outstanding balance of a mortgage pool will prepay

each year See also Public Securities Administration prepayment model and Single monthly mortality.

Conforming mortgage. A mortgage loan that meets all requirements (loan type, amount, and age) for purchase bythe Federal Home Loan Mortgage Corporation or Federal National Mortgage Association

Conventional mortgage. A mortgage loan that is not government -guaranteed or governmnet-insured There are

two types of conventional loans, conforming and nonconforming See also Conforming mortgage and

Nonconforming mortgage.

Convertible mortgage. An adjustable-rate mortgage that may be converted to a fixed-rate mortgage at one or morespecified times over its term

Correspondent. A mortgage banker that originates mortgage loans that are sold to other mortgage bankers

Direct endorsement (DE). A Department of Housing and Urban Development (HUD) program that enables an eligiblelender to process and close single-family applications for Federal Housing Administration-insured loans without HUD’sprior review

Discount rate. The time value of money can be interpreted as the rate at which individuals are willing to trade presentfor future consumption, or the opportunity cost of capital Mathematically, the discount rate represents the rate at whichfuture dollars are converted into present value This rate can be used to calculate the present value of future cash flowstreams generated by mortgage servicing rights.

Escrow. The portion of the borrower’s monthly payments held by the servicer to pay taxes, insurance, mortgageinsurance (if required), and other related expenses as they become due In some parts of the U.S., escrows are alsocalled impounds or reserves

Escrow analysis The periodic review of escrow accounts to determine if current monthly deposits will provide

sufficient funds to pay taxes, insurance, and related expenses when due

Excess servicing fee. The interest rate spread between the weighted average coupon rate (WAC) of a mortgage loanpool and the pass-through interest rate after deducting the servicing fee and the guarantee fee For example, when theWAC is 9.00 percent for the pool, the pass-through rate is 8.50 percent, the servicing fee is 0.25 percent, and theguarantee fee is 0.21 percent, the excess servicing fee is 0.04 percent

Excess servicing fee receivable (ESFR). The present value of the projected future cash flows generated by theexcess servicing fee This calculation requires application of a discount rate and must reflect the expected prepaymentrate of the underlying loan

Fallout. Loans in the pipeline not expected to close

Federal Home Loan Mortgage Corporation (FHLMC) also called Freddie Mac A stockholder-owned corporation

created by Congress in the Emergency Home Finance Act of 1970 (12 U.S.C 1451) Freddie Mac operates

mortgage purchase and securitization programs to support the secondary market in mortgages on residential property

Federal Housing Administration (FHA). A federal agency of the Department of Housing and Urban Development(HUD) established in 1934 under the National Housing Act The FHA supports the secondary market in mortgages onresidential property by providing mortgage insurance for certain residential mortgages

Federal National Mortgage Association (FNMA) also called Fannie Mae A stockholder-owned corporation

created by Congress in a 1968 amendment to the National Housing Act (12 U.S.C 1716) Fannie Mae operatesmortgage purchase and securitization programs to support the secondary market in mortgages on residential property

FHA loan. A loan, made through an approved lender, that is insured by the Federal Housing Administration

FHA value. The value established by the Federal Housing Administration as the basis for determining the maximummortgage amount that may be insured for a particular property The FHA value is the sum of the appraised value plusthe FHA estimate of closing costs

FHLMC See Federal Home Loan Mortgage Corporation.

Fixed-rate mortgage (FRM). An amortizing mortgage for which the interest rate and payments remain the same overthe life of the loan

Float. In mortgage servicing, the period of time between receipt of a borrower’s loan payment and remittance of funds

to investors

Floor (interest rate) An investor safeguard on an adjustable-rate mortgage that limits the amount the interest rate

may decline per period and/or over the life of the loan See also Cap

FNMA. See Federal National Mortgage Association.

Forbearance. In mortgage banking, the act of refraining from taking legal action when a mortgage is delinquent Forbearance usually is granted only if a borrower has made satisfactory arrangements to pay the amount owed at afuture date

GNMA I. A mortgage-backed security program in which individual mortgage lenders issue securities backed by the

“full faith and credit of the United States government.” The mortgages comprising the security are government-insured

or government-guaranteed The issuer is responsible for passing principal and interest payments directly to thesecurities holders, whether or not the homeowner makes the monthly payment on the mortgage All mortgages in aGNMA I pool must have the same note rate

GNMA II. A mortgage-backed security program in which individual mortgage lenders issue securities backed by the

“full faith and credit of the United States government.” The mortgages comprising the security are government-insured

or government-guaranteed The issuer is responsible for passing principal and interest payments to a central payingagent whether or not the homeowner makes the monthly payment on the mortgage The central paying agent thenpasses principal and interest payments to the securities holders GNMA II pools are generally larger than thoseformed under GNMA I and may include mortgages with different note rates

Government National Mortgage Association (GNMA) also called Ginnie Mae A federal government corporation

created as part of the Department of Housing and Urban Development in 1968 by an amendment to the NationalHousing Act (12 U.S.C 1716) GNMA guarantees mortgage-backed securities that are insured by the FederalHousing Administration or guaranteed by the Veterans Administration and backed by the full faith and credit of the U.S.government

Government-sponsored enterprise (GSE). A private organization with a government charter and backing TheFederal Home Loan Mortgage Corporation and the Federal National Mortgage Association are GSEs

Graduated payment mortgage (GPM). A flexible payment mortgage in which the payments increase for a specifiedperiod of time and then level off GPMs usually result in negative amortization during the early years of the mortgage’slife

Growing equity mortgage (GEM). A graduated payment mortgage in which increases in the borrower’s mortgagepayments are used to accelerate reduction of principal on the loan These graduated payment loans do not involvenegative amortization

Guarantee fee. The fee paid to a federal agency (or private entity) in return for its agreement to accept a portion of theloss exposure Currently, typical guarantee fees required by the Federal Home Loan Mortgage Corporation and theFederal National Mortgage Association for loan sales without recourse range from 0.16 percent to 0.25 percent of thepool balance annually The Government National Mortgage Association guarantee fee on pools of federally insured orguaranteed loans is lower, 0.06 percent annually

Guarantee fee buy-down. An arrangement in which the seller of mortgages pays a lower guarantee fee in return for

less cash when the loans are sold Guarantee fee buy-downs allow a bank to collect a higher excess servicing fee

over the life of the serviced loans See also Guarantee fee.

Guarantee fee buy-up. An up-front fee paid to a loan seller in exchange for a higher guarantee fee Guarantee feebuy-ups increase the cash received for the mortgages when they are sold, and reduce the excess servicing fee to be

collected over the life of the underlying serviced loans See also Guarantee fee.

Hazard insurance. Insurance coverage that protects the insured in case of property loss or damage

Investor. A person or institution that buys mortgage loans and/or securities, or has a financial interest in these

Margin. In an adjustable-rate mortgage, the spread between the index rate used and the mortgage interest rate

Mortgage banker. An individual or firm that originates, purchases, sells, and/or services loans secured by

mortgages on real property

Mortgage broker. An individual or firm that receives a commission for matching mortgage borrowers with lenders Mortgage brokers typically do not fund the loans they help originate

Mortgage insurance (MI). Insurance coverage that protects mortgage lenders or investors in the event of default bythe borrower By absorbing some of the credit risk, MI allows lenders to make loans with lower down payments Thefederal government offers MI for Federal Housing Administration loans; private companies offer MI for conventional

loans See also Private mortgage insurance

Mortgage pool. A group of mortgage loans with similar characteristics that are combined to form the underlyingcollateral of a mortgage-backed security

Mortgage Servicing Rights (MSR) The rights to service a mortgage loan or a portfolio of loans for other than abank’s own account The cost associated with acquiring these rights may be capitalized under certain circumstances

See also Purchased mortgage servicing rights and Originated mortgage servicing rights.

Negative amortization. The situation that arises when the periodic installment payments on a loan are insufficient torepay principal and interest due Due but unpaid interest is added to the principal of a mortgage loan causing the loanbalance to increase rather than decrease

Negative carry also called negative spread In warehousing, the expense incurred when the interest rate paid for

short-term warehouse financing is greater than the interest rate earned on the mortgages held in the warehouse.

Nonconforming mortgage. A mortgage loan that does not meet the standards of eligibility for purchase or

securitization by Federal Home Loan Mortgage Corporation or the Federal National Mortgage Association The loanamount, the loan-to-value ratio, the term, or some other aspect of the loan does not conform to the agencies’ standards

Nontraditional mortgage product. A type of mortgage that is unlike the typical mortgage instrument Lenders maycreate nontraditional mortgages that vary the expected amount of principal, the interest rate, the periodic or monthlypayments, borrower income and employment documentation and verification, or repayment terms

Normal servicing fee. The rate representative of rates an investor pays to the servicer for performing servicing dutiesfor similar loans The servicing fee rates set by GNMA and GSEs are generally considered normal servicing fees Currently, the normal servicing fee rate is 0.25 percent for fixed rate mortgages, 0.375 percent for adjustable-ratemortgages, and 0.44 percent for federally insured and guaranteed loans A bank may not use its cost to service loans

as the normal servicing fee

Optional delivery commitment also called standby commitment An agreement that requires an investor to buy

mortgages at an agreed-upon price The seller is not, however, required to sell or deliver a specified amount ofmortgages to the investor

Originated mortgage servicing rights (OMSR) The right to service a mortgage loan acquired through loan

origination activities The servicer receives an income stream in the form of a contractual servicing fee every period

until the maturity of the mortgage, prepayment, or default See also Retail production and Mortgage servicing

Pair-off fee. See Pair-off arrangement.

Participation certificate (PC). A mortgage pass-through security issued by the Federal Home Loan MortgageCorporation that is backed by a pool of conventional mortgages purchased from a seller and in which the seller retains

a 5 percent to 10 percent interest

Pass-through. A mortgage-backed security in which principal, interest, and prepayments are passed through to theinvestors as received The mortgage collateral is held by a trust in which the investors own an undivided interest

Pass-through rate. The interest rate paid to the investors who purchase mortgage loans or mortgage-backed

securities Typically, the pass-through rate is less than the coupon rate of the underlying mortgage(s)

Pipeline. In mortgage lending, applications in process that have not closed

Pledged account mortgage (PAM). A graduated payment loan in which part of the borrower’s down payment isdeposited into a savings account Funds drawn from the account supplement the borrower’s monthly payments duringthe early years of the mortgage.

Pool. A collection of mortgage loans with similar characteristics

Positive carry , also called positive spread In warehousing, the excess income that results when the interest rate

paid for short-term warehouse financing is less than the interest rate earned on the mortgages held in the warehouse

Prepayment. The payment of all or part of a loan before it is contractually due

Prepayment speed. The rate at which mortgage prepayments occur or are projected to occur, expressed as a

percentage of the outstanding principal balance See also Conditional prepayment rate, Public Securities

Administration prepayment model, and Single monthly mortality

Price level adjusted mortgage (PLAM). A mortgage loan in which the interest rate remains fixed, but the outstandingbalance is adjusted for inflation periodically using an appropriate index such as the Consumer Price Index or Cost-of-Living Index At the end of each period, the outstanding balance is adjusted for inflation and monthly payments arerecomputed based on the new balance

Primary market. For a mortgage lender, the market in which it originates mortgages and lends funds directly to

homeowners

Principal only strips (POs). A security that pays only the principal distributions from a pool of underlying loans Theinterest cash flows from the underlying loans are paid to a separate interest only (IO) security The cash flows from theunderlying loans are thus “stripped” into two separate securities Because the PO holder receives only principaldistributions, the value of the PO rises when prepayments on the underlying loans increase, since a fixed amount ofcash flow is received sooner than anticipated As a result, mortgage bankers often use PO’s to hedge the value ofservicing rights, which have cash flow risks similar to IO securities

Private mortgage insurance (PMI). Insurance coverage written by a private company that protects the mortgage

lender in the event of default by the borrower See also Mortgage insurance.

Production flow. The purchase of mortgage loans in combination with the rights to service those loans The entity

acquiring the mortgage loans then resells the loans but retains the accompanying servicing rights See also

Purchased mortgage servicing rights

Public Securities Administration (PSA) prepayment model. A standard of measurement of the projected annualrate of prepayment for a mortgage loan or pool of loans A 100 PSA prepayment rate assumes that loans prepay at a

6 percent annual rate after the 30th month of origination From origination to the 30th month, the annualized prepaymentrate increases in a linear manner by 0.2 percent each month (6 percent divided by 30) For example, the annualizedprepayment on a pool of mortgages would be 0.2 percent when the loans are 1 month old, 1 percent when the loansare 5 months old, 4.8 percent at 24 months, and 6 percent at 30 months and beyond PSA speeds increase ordecrease to reflect faster or slower prepayment projections To illustrate, 200 PSA after the 30th month equals a 12

percent annual prepayment rate; and 50 PSA equals a 3 percent annual prepayment rate See also Conditional

prepayment rate and Single monthly mortality.

Purchased mortgage servicing rights (PMSR) The rights to service a mortgage loan acquired by purchase The

servicer receives an income stream in the form of a contractual servicing fee for every period until the mortgage

matures, is prepaid, or goes into default See also Bulk acquisition and Production flow.

Quality control. In mortgage banking, policies and procedures designed to maintain optimal levels of quality,

accuracy, and efficiency in producing, selling, and servicing mortgage loans

Retail production Mortgage loans generated through origination activities which close in the bank’s or a subsidiary’s

name See Originated mortgage servicing rights

Reverse annuity mortgage (RAM). A mortgage loan in which the lender makes periodic payments to the borrower

in return for an increasing equity interest in the underlying property RAMs are frequently made to retirees who owntheir residences outright

Seasoned mortgage portfolio. A mortgage portfolio that has reached its peak delinquency level, generally after 30 to

48 months

Secondary mortgage market. The market in which lenders and investors buy and sell existing mortgages

Servicing , also called loan administration A mortgage banking function that includes document custodianship,

receipt of payments, cash management, escrow administration, investor accounting, customer service, loan setup andpayoff, collections, and other real estate owned administration

Servicing agreement. A written agreement between an investor and a mortgage servicer stipulating the rights andobligations of each party

Servicing fee. The contractual fee due to the mortgage servicer for performing various loan servicing duties forinvestors

Servicing released. A stipulation in a mortgage sales agreement which specifies that the seller is not responsible forservicing the loans

Servicing retained. A stipulation in a mortgage sales agreement which specifies that, in return for a fee, the seller isresponsible for servicing the mortgages

Servicing runoff. Reduction in the principal of a servicing portfolio resulting from monthly payments, mortgageprepayments, and foreclosures Runoff reduces future servicing fee income and other related cash flows as well as thecurrent market value of the servicing portfolio

Settlement. The consummation of a transaction In mortgage lending, the closing of a mortgage loan or the delivery of

a loan or security to a buyer See also Closing.

Shared appreciation mortgage (SAM). A mortgage loan in which the lender offers the borrower a below-marketinterest rate in exchange for a portion of the profit earned when the property is sold

Short sale. An arrangement entered into between a loan servicer and a delinquent borrower The servicer allows theborrower to sell the property to a third party at less than the outstanding balance This saves the servicer the time andexpense involved in a foreclosure action The servicer must normally obtain the approval of the investor before

entering into a short sale agreement See also Forbearance.

Single monthly mortality (SMM). SMM is the conditional prepayment rate (CPR) expressed on a monthly basis

Standby commitment. See Optional delivery commitment.

Table funding. A method of acquiring mortgage loans from a non-affiliated source, usually a correspondent Theacquiring party funds the mortgage at closing If certain conditions are met, the right to service table funded loans may

be capitalized as purchased mortgage servicing rights

VA loan. A loan made through an approved lender and partially guaranteed by the Veterans Administration

VA no-bid. An option which allows the Veterans Administration (VA) to pay only the amount of its guarantee on adefaulted mortgage loan, leaving the investor with the title to the foreclosed property The VA must exercise this optionwhen it is in the government’s best interest No-bid properties become other real estate owned

Veterans Administration (VA). The traditional name for the Department of Veterans Affairs, now a cabinet-levelagency of the U.S government The Servicemen’s Readjustment Act of 1944 authorized the VA to offer the HomeLoan Guaranty program to veterans The program encourages mortgage lenders to offer long-term, low down

payment financing to eligible veterans by partially guaranteeing the lender against loss

Warehouse (loan). In mortgage lending, loans that are funded and awaiting sale or delivery to an investor

Warehouse financing. The short-term borrowing of funds by a mortgage banker based on the collateral of

warehouse loans This form of interim financing is used until the warehouse loans are sold to a permanent investor

WARM. See Weighted average remaining maturity.

Weighted average coupon (WAC). The weighted average of the gross interest rates of the mortgages in a

mortgage pool The balance of each mortgage is used as the weighting factor

Weighted average maturity (WAM). The weighted average of the remaining terms to maturity of the mortgages in amortgage pool as of the security issue date

Weighted average remaining maturity (WARM). The weighted average of the remaining terms to maturity of themortgages in a mortgage pool subsequent to the security issue date The difference between the weighted averagematurity and the weighted average remaining maturity is known as the weighted average loan age (WALA)